I have been asked to comment on a large income tax liability incurred by the trustees of a discretionary trust created in a Will, but I am going round in circles, so would appreciate any words of wisdom from members of the forum please!
The trust was created during tax year 22/23 and contains a rental property and some cash, the total value of which are within the NRB. The trustees have power to pay or apply income and capital for the benefit of the beneficiaries, as well as the usual powers to accumulate income and wide powers of appointment.
Since the trust started, the trustees have paid the whole of the gross rent they have received each month to two of the beneficiaries, with the intention that any income tax and property related expenses would be paid from the capital cash in the trust. It has now come to light that this arrangement may have breached the tax pool and landed the trustees with an unexpected tax bill.
The trustees have an accountant who prepares their annual trust tax returns, R185’s and accounts. The accountant was made aware that the rent would all be distributed and the income tax etc would be paid from the capital cash, but did not at this stage advise the trustees that this would create any additional tax burden for them.
When the accountant prepared the tax return and accounts for 22/23, they also did not specifically advise the trustees that their actions meant that an income tax penalty (tax pool adjustment) of £1,500 formed part of their tax bill, or advise them what steps to take to ensure this didn’t happen in the following year.
In 23/24, one of the beneficiaries approached the trustees and asked if they could receive a lump sum equal to several months’ rent “up front” to use as a house deposit. The trustees were willing (in principle) to facilitate this, but did not have any accumulated income to pay this from, so it was assumed that the payment would have to be made from the capital cash. The accountant was asked to confirm their agreement with this approach, but advised that HMRC would treat this as an income payment, as the beneficiary had received income previously, so was entitled to it, irrespective of the fact this is a discretionary trust.
The trustees therefore signed their first and only Resolution, to confirm their decision to pay the lump sum to the beneficiary using their power to apply income, to stop making payments of income to her for X months and then recommence them at the end of that period, until such time as they determined otherwise. They also confirmed their decision to continue paying income to the second beneficiary.
The accountant has now prepared the tax return and accounts for 23/24 which has revealed large negative balance on the income account and a huge income tax liability, as there was an insufficient balance in the tax pool to frank the “income payments” that were made during the tax year.
I have considered this for the trustees, but cannot understand how the lump sum payment can have been made to the beneficiary from income and feel it must have been made from capital. Each month, the trustees had distributed all of the income to the beneficiaries leaving a nil balance on the income account so, presumably, any payment they made can only have been made from capital? I think the Resolution was therefore incorrect as the trustees simply did not have the funds available to them to resolve to pay the lump sum from income.
I am minded to suggest that the trustees sign some sort of “corrective Resolution” to confirm the trust position and then disclose both to HMRC and ask them to confirm that they agree with our interpretation, but the accountant does not feel this would work. The alternative would be to approach Counsel for advice.
Am I missing something obvious here? Is it possible to end the tax year with a negative balance on the income account and therefore effectively incur a tax liability for breaching the tax pool based on the fact it was a distribution of “future income”? Or is it not simply a matter of fact that the lump sum payment must have been made from capital as there was no accumulated income in the trust?